Strategy Spotlight

Valuation Matters: Rob Arnott on Equity Market Dynamics and the Outlook for the PIMCO RAE Fundamental Strategies

Launched over a decade ago, well before the term “smart beta” was coined, the PIMCO Research Affiliates Equity (RAE) Fundamental equity strategies have successfully navigated through the financial crisis and an extraordinary market environment in which growth has outperformed value for an extended period. Recently, however, the outperformance of growth versus value has intensified, and this has challenged RAE Fundamental equity strategies. In the following interview, Research Affiliates Chairman and smart beta investing pioneer Rob Arnott provides his perspective on recent market dynamics and why these strategies may present unique opportunities for equity investors today.

Q: Rob, you are broadly credited with pioneering the “smart beta” movement. You are also a portfolio manager for the PIMCO RAE Fundamental equity strategies. Remind us of the philosophy and process behind these strategies.
Rob Arnott:
PIMCO RAE Fundamental is based on a simple premise: Valuation matters. At its core, as is the case with smart beta strategies more broadly, it is a contrarian rebalancing strategy designed to outperform the market by breaking the link between price and portfolio weighting in order to systematically take advantage of the market’s constantly changing sentiment.

RAE Fundamental, which is exclusively available through PIMCO, has continuously evolved based on our latest research findings. These equity strategies build upon Research Affiliates’ original work on the Fundamental Index methodology by incorporating additional insights on smart beta, return premia, risk diversification and implementation.

The PIMCO RAE Fundamental portfolios start with a fundamentals-based portfolio construction process, selecting and weighting companies by fundamental measures of size – sales, cash flow, dividends and book value. Rebalancing to these fundamental weights helps the portfolios adhere to the “buy low, sell high” axiom. The act of rebalancing is inherently contrarian. In effect, it requires the sale of the market’s most sought-out companies and the purchase of out-of-favor companies. PIMCO RAE Fundamental portfolios position themselves to take advantage of mean reversion as a result.

Additionally, PIMCO RAE Fundamental equity portfolios incorporate momentum and quality screens, plus processes designed to diversify active weights. The momentum screen seeks to protect against catching the proverbial “falling knife” while also working to avoid rebalancing aggressively out of a rapidly appreciating position. The quality – or financial health – screen incorporates a number of measures designed to reduce or eliminate exposure to companies that are either distressed, lacking growth prospects or applying aggressive accounting techniques. And the risk-diversification processes redistributes active “bets” with the goal of optimizing long-term risk-adjusted returns.

Q: Performance has been challenged as of late. Why?
When appropriately implemented, a contrarian, disciplined, fundamentally-weighted approach should add value over the long run so long as stock prices continue to mean-revert after deviating from their intrinsic fair value – as they have throughout history. However, mean-reversion timing is inherently difficult to predict. Trends often last longer than any reasonable valuation measure would suggest they should. The screens embedded in the PIMCO RAE Fundamental portfolio construction process are helpful, but have not been enough to prevent a contrarian strategy with a disciplined rebalancing approach from lagging in a market where value has underperformed growth by over 8% globally1 over the past 12 months ended September 2015.

The PIMCO RAE Fundamental strategies attempt to systematically access the value premium efficiently via rebalancing, although the degree of value exposure varies over time. The value tilt will be lower when value companies are relatively expensive, and the value tilt will be higher when value companies are relatively cheap. This means that at the moment, the value tilt is higher than average, creating both a meaningful headwind for recent returns and fabulous positioning going forward. History has repeatedly shown us that due to the power of mean reversion, rebalancing can work over the long run, and conditioning a valuation-biased portfolio on other systematic exposures, namely quality and momentum, may lead to even better outcomes.

Q: On a more granular level, what exposures contributed to recent underperformance?
Arnott :
The names vary by region, but the value underperformance I mentioned can be traced to a few primary drivers. Commodities-related businesses have been punished recently, while the internet and biotech industries have seen valuations continue to rise.

Energy firms have suffered as the price of oil has fallen, and RAE rebalanced into high-quality energy firms as they fell in price only to see them become cheaper still. Now that oil is below $50/barrel, the markets fear it will fall to $20/barrel, and fear is an inherently uncomfortable feeling. Yet, sometimes the best investment opportunities are those that are uncomfortable. (It was not that long ago that the dominant fear was $200/barrel oil – in 2008 when oil was trading around $130). There is no question that higher oil prices are generally better for energy companies than lower oil prices. The more relevant question for investors relates to current valuations. Is the decline and potential future decline in oil prices properly reflected in prices today, or has the market over-extrapolated? A lot of bad news is priced into this sector in developed markets. Even more is priced into energy companies in emerging markets.

Biotech and select internet companies constitute the other side of this story. As these industries have continued to appreciate, relatively speaking, the RAE process has resulted in underweights that have negatively affected performance versus cap-weighted index benchmarks. For reference, the price-to-sales ratio for biopharma firms in the Russell 2000 was 14x at the end of August versus a sector average of 1x for the rest of the index. (I have to quote a sales, not earnings, multiple for these firms as many of them do not even have earnings!) And within the S&P 500, the current price-to-earnings ratio is close to 40x and 30x for the internet and catalog retail and internet software and services industries, respectively, versus 18x for the S&P 500 as a whole as of September 30.

Q: What do you expect from the RAE Fundamental strategies going forward?
The extraordinary divergence in growth versus value is noteworthy, and not entirely dissimilar from certain market characteristics circa 1999, in the months leading up to the burst of the tech bubble. Interestingly enough, it was our observations in the aftermath of the tech bubble that led to our work on the Fundamental Index methodology. We may not know exactly which stocks are overpriced and underpriced – and by how much – but we do know that the stock market is not perfectly efficient. We have been taught this again and again.

Likewise, we do not have an opinion on the appropriate valuation levels for specific companies, but we do know that valuation matters. Mean reversion is a powerful force, and due to the disciplined process that we follow, we believe that the PIMCO RAE Fundamental portfolios will be well-positioned when it happens. Growth has outperformed value by about 2% 2 per year since the launch of the original RAE Fundamental strategies over a decade ago, in contrast to the typical well-documented value return premium. Between the possibility for mean reversion and the potential for the return of the value premium, I believe that these strategies offer a relatively unique and attractive investment opportunity today.

1 Based on the performance of MSCI All Country World Index Value (-10.79%) vs. Growth (-2.48% for 12 months ended 30 September 2015.

2Based on the performance of Russell 1000 Value (5.82%) vs. Russell 1000 Growth (7.71%) from 31 December 2014 through 30 September 2015.

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Robert Arnott

Founder and Chairman, Research Affiliates

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PIMCO Australia Pty Ltd
ABN 54 084 280 508
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Level 19, 5 Martin Place
Sydney, NSW 2000

Past performance is not a guarantee or a reliable indicator of future results . All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

The MSCI ACWI Growth Index captures large and mid-cap securities exhibiting overall growth style characteristics across 23 Developed Markets (DM) countries and 23 Emerging Markets (EM) countries. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend. The MSCI ACWI Value Index captures large and mid-cap securities exhibiting overall value style characteristics across 23 Developed Markets countries* and 23 Emerging Markets (EM) countries*. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield. With 1,313 constituents, the index targets 50% coverage of the free float-adjusted market capitalization of the MSCI ACWI Index. The Russell 1000 Index consists of the 1,000 largest securities in the Russell 3000 Index, which represents approximately 90% of the total market capitalization of the Russell 3000 Index. It is a large-cap, market-oriented index and is highly correlated with the S&P 500 Index. The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

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